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If Amazon’s 68 million active customers all lived in the same country, it would be the world’s 19th most populous country, with more citizens than every European country except Germany. And if every US household spent $170 at Amazon.com this year, the total amount they’d spend would still be less than Amazon’s 2010 revenues of over $34.2B.[1] Amazon has used the internet to create a truly global business platform, one which is poised for incredible growth in the coming decade. The question in many investors' minds these days is how profitable that business can be.

While most people naturally think of Amazon as the internet superstore that sells products in over forty categories, from books to electronics to groceries to jewelry to auto parts, the company has gradually expanded beyond that simple business platform; today Amazon is simultaneously an e-commerce and internet technology platform, a fulfillment and logistics platform, a search technology, an internet advertising platform, and even an internet startup incubator.

Founded in 1995 by Jeff Bezos as an online bookstore, Amazon has since greatly expanded its business. Today, Amazon’s stated mission is to be a place where “people can come to find and discover anything they might want to buy online.” Its key pillars of lowering price, offering convenience, expanding selection, and increasing availability are interrelated in what the company calls a virtuous cycle, and together make up the foundation of the fabulous growth that has taken Amazon from a bookstore started in a garage to a $48B retail machine. Amazon’s direct-to-consumer online model allows it to keep its inventory in a small number of strategically located large warehouses, letting the company offer a vast selection of goods (removing the granularity risk of relying on any particular product line) and without the capital investment and inventory risk that traditional brick and mortar retailers face.

In comparison to brick and mortar retailers, whose input costs (e.g. rent, utilities, and labor) generally rise over time, Amazon and other technology-dependent internet retailers reap the benefits of technological progress as computational power, bandwidth, and data storage technologies all improve in quality and decline in cost over time.

In addition, due to sophisticated inventory forecasting, fast inventory turns, and overall operational efficiency, Amazon has managed to build a retail business with a negative operating cashflow cycle, which means Amazon gets paid for products by customers before they have to pay their suppliers for the goods. Working capital has effectively become a source of investment cash for the company.

Category Expansion

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Category Growth Rates

Although roughly 64%[4] of Amazon's worldwide revenue still comes from media categories (books, music, video), Amazon's product footprint in the US has expanded into over 40 categories. New product categories represent significant growth opportunities for the company, given the lower online penetration rates in many of these categories. Revenue and income growth rates for these categories have regularly outpaced the growth in media categories both in the US and abroad.

Amazon’s digital media store has seen substantial investment from the management, and investors have been anxiously awaiting the launch of new initiatives in downloadable music, video, and text.

International Expansion

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Historical Category Expansion

International businesses have represented a significant area of growth for Amazon. Although Amazon ships to almost any country in the world, it has selectively chosen to establish country-specific websites and fulfillment networks. Beginning with its expansion into the UK and Germany in 1998, and subsequently to France (2000), Japan (2000), Canada (2002), China (2004) Italy (2010), and Spain (2010), Amazon has expanded its geographic footprint into the world’s major e-commerce markets. International growth rates have consistently beaten that of North America.

This is due in part to the relative maturity of the US market, as well as to the strategy Amazon has employed in rolling out new product categories and features to its international properties. Amazon has typically introduced most of its new stores and features in the US market first, eventually replicating the most successful ventures in international markets.
Amazon's international businesses have thus been able to benefit from experience gained through US experiments to grow at an accelerated pace.

Third Party Seller Marketplace

Years ago, Amazon also made a strategic decision to open up its website and create a Marketplace of third party sellers who effectively compete with Amazon for any given sale. These merchants sell a variety of new and used products for which Amazon receives a commission on products sold via its Marketplace, and although gross margins on these transactions is generally less than that if Amazon sold the item directly, the Marketplace strategy creates a one-stop shopping destination with a consistent experience for the customer. It has also helped Amazon dramatically increase its selection of available products. The bet seems to have been a smart one -- 30% of items sold on Amazon are sold by third parties.

Other Businesses

Amazon is not just in the business of selling products via the Internet. It has also started businesses to:

Sell its technology to other retailers (E-commerce platform sales)

Sell its fulfillment and customer services capabilities to sellers (Fulfillment by Amazon)

Sell its technology infrastructure via a set of web services technologies that enable developers to use Amazon's servers (EC2, S3, SQS)

Operate a family of other websites:

A9.com (search subsidiary)

Abebooks.com

Alexa.com (web search and metrics subsidiary)

Askville.com (question/answer marketplace)

Audible.com

Diapers.com

Endless.com (shoe and handbag store)

IMDb.com (Internet Movie Database)

Mturk.com (human task marketplace)

Shopbop.com

Soap.com

Zappos.com

In addition, Amazon has had a longstanding policy of being very quiet about new initiatives it is working on, so it is safe to assume that there are many other projects in the works that are not known to the public.

Unfortunately for investors, another one of Amazon's longstanding policies is of being extremely tight-lipped about reporting financials broken out by its various business lines, so there is little visibility into how any particular sub-business contributes to the company's financial performance.

That being said, it is still possible to evaluate the company according to important issues that these businesses face.

Hot Button Topics

Given the breadth of businesses that Amazon takes part in, there are a wide variety of issues that affect the company. Some of the most important issues are discussed below.

Digital media: disappearing opportunity

Although Amazon has grown its business in many ways in its twelve year history, its origins as a bookseller are still evidenced by the company’s significant revenue from media categories. It is these same categories that are most impacted by the emergence of digital content and delivery. The growth of downloadable forms of music, video, software, electronic books, and other digital products represent both a significant risk to Amazon’s existing media businesses and a significant opportunity for the company.

In 2007, the company opened Amazon MP3, its digital music store, in a move viewed as a direct challenge to Apple’s iTunes distribution platform. Amazon's digital offerings were differentiated by two key factors:

Lower prices - Songs are being offered at a 10-cent discount to those found on iTunes

Lack of DRM - All songs offered by Amazon will be free of copyright protection features that typically lock the song from particular forms of use.

Although Amazon recently released Unbox, its video download service, it is far from dominating the sector. Downloadable video for purchase faces competition from the growth of independent online video and charge-free offerings such as YouTube. The initial launch of Unbox was also criticized for being hampered by useability issues--reviewers complained about long download times and limited playback capabilities, caused in part by strict digital rights management limitations. A recent partnership was announced with Tivo that may help improve the Unbox offering, but adoption of Unbox has yet to see significant growth.

Amazon Kindle

On November 19, 2007, Amazon announced the launch of its first consumer electronics device, the Amazon Kindle. Quickly dubbed by the media as "the iPod of reading", the device follows Apple'siPod strategy of coupling a electronic media device with the sale of digital media -- in this case, not just books but also other digital text media. It also uses Whispernet, a 3G wireless EVDO connection provided by Sprint to download books, blogs, newspapers, and other websites. While there have been multiple attempts by consumer electronics manufacturers such as Sony to develop e-book readers, none have yet resulted in broad consumer adoption. But Amazon's dual role as consumer electronics manufacturer and digital distribution channel might be just what the market needs to spur an e-book revolution. With a unit cost with books priced under $10 and blogs and magazines billed on a monthly subscription model, there are multiple revenue streams that Amazon could benefit from should the Kindle take off. Amazon is also trying to penetrate the text-book market with the Kindle.

Since April 2010, the Kindle has faced competition from the AppleiPad. Publishers who are not happy with Amazon's e-book pricing model have entered into disputes with Amazon, embracing the iPad. Amazon may be forced to offer publishers more generous rates for their titles, thus making the Kindle less competitive with ordinary books.[5]

Amazon Prime: good or bad?

Amazon Prime is an “all you can eat” shipping program where customers pay an annual fee (currently $79) to get unlimited express shipping for most products sold directly by Amazon. While few metrics have been released by the company regarding the number of customers who have joined Prime or the exact impact the program has had on increasing revenues, management has repeatedly stated that the program is having very positive effects on increasing revenues and overall loyalty to Amazon. Critics of the program often speculate that Prime is a likely driver of the increase in shipping costs incurred by Amazon in recent quarters (in addition to fuel surchages imposed by carriers due to the rising price of oil. But like many other components of Amazon's business strategy, these shipping costs could decrease over time should the adoption of Prime increase to a level where certain economies of scale can be achieved with express shipping vendors.

Ecommerce platform: losing partners

One of Amazon’s businesses is the reselling of the ecommerce technology platform to other retailers who want to use its technology. Given that Amazon invests over half a billion dollars each year in developing its technology, it makes sense that Amazon would try to generate revenue from its technology platform. Current customers of Amazon technology include: Target, Sears Canada, Marks and Spencer, The Bombay Company, and NBA.com. But in recent history, there seems to be increasing reports of ruffled feathers between Amazon and its e-commerce partners. In February 2005, Circuit City ended its partnership with Amazon. Then in September 2006, Amazon and former partner Toys 'R Us abruptly ended their partnership and promptly sued each other for breach of contract. And in March 2007, long time partner Borders announced that it would be severing ties with Amazon and pursuing its own online offering, a divorce that analysts at Stifel, Nicolaus, and Co. estimate could cost Amazon $80-160MM in lost revenue each year.

Amazon has also been slow to drum up new ecommerce platform partnerships--perhaps an indication that it is having trouble competing with GSI Commerce and other players in the space who do not suffer from the potential conflict of interest and inherent competition with partners that stems from Amazon's role as both a technology platform provider and a retailer.

Bundling services: Economies of Scale

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Amazon fulfillment center

Part of Amazon’s strategy in selling ecommerce services is to leverage its economies of scale to bring greater efficiency and lower prices to the market. Amazon has extended this strategy beyond its ecommerce technology platform to a whole slew of other platform services within the cloud computing industry. Bundled as Amazon Services, these offerings include Fulfillment by Amazon (lets sellers outsource the fulfillment of their sales by shipping their products in bulk to Amazon’s warehouses so that Amazon can handle fulfillment to the customer), WebStore by Amazon (lets sellers use Amazon’s technology to power their own independent online stores), and the Pro Merchants platform (provides small businesses with tools to help them sell their products on Amazon.com).

In addition to services offered as part of its retail ecommerce platform, Amazon has recently entered into a whole new arena with its Web Services offerings. Many of these services follow the philosophy of leveraging and increasing Amazon’s economies of scale by allowing access to its infrastructure, but in the world of creating a open computing platform. Elastic Compute Cloud (EC2) lets software developers use Amazon’s computing infrastructure to host their web applications. Amazon is moving ahead of its competition with this product, announcing in April 2008 that it would provide persistent storage for EC2. This announcement is causing some to claim that Amazon's future may be based on its web services rather than its retail business.[6] Storage Service (S3) lets developers store data in Amazon’s data centers. The company promises more of these technology building blocks in the future, hoping to eventually create a broad and interoperable computing platform.

There is incredible potential for growth and revenues associated with these Amazon Services products, but most of these bets represent long term growth opportunities still in the infancy of development. Given the uncertainty of these businesses, management has been cautiously silent about offering any revenue projections.

Joyo: Amazon in China

Much of the world has focused on China as the next major world market, and Amazon is no different. In 2004, Amazon acquired major Chinese ecommerce retailer Joyo.com for $75MM, and has slowly integrated components of its global platform into Joyo in the years since. Despite these efforts, Joyo has seen slower growth than competitor Dangdang.com.

Development online: A9, Clickriver

In 2004, Amazon spun out a subsidary company called A9 to focus on building search technology and a search portal. Although Amazon has invested substantial resources in A9 in three years since, A9 has seen little success in building out a consumer brand as a search portal. In recent months, A9 begun to head down a different path--this time it will focus on building a product search portal.

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Perhaps one of the more promising revenue generating initiatives A9 is working on is Clickriver, A9/Amazon's sponsored advertising platform. In much the same way that internet search giant Google rakes in revenues from sponsored advertising, A9 hopes that its advertising platform, now in beta testing, will bring in high profits from advertisers on Amazon.com.

Amazon’s billions of pageviews each year represent a huge opportunity for advertising-based revenue. For years, Amazon has kept advertising to a minimum on their website, preferring to generate revenues through strategic partnerships with companies like travel partner Hotwire and financial services partner Fidelity. But in late 2006, the company quietly launched Clickriver. Although still young, Clickriver could represent a very significant high-margin revenue opportunity for Amazon if there are enough interested advertisers. And if Clickriver is successful, Amazon could get a lot deeper in the advertisement targeting and brokering business by using the information it gathers about its customers to target ads both on and off Amazon.

State Sales Tax Treatment

Amazon has avoided being subject to state sales tax in many states. Several states have attempted to pass laws to obtain revenues from these sales. In June 2009, North Carolina passed a tax law which would allow them to tax Amazon sales on the basis of Amazon having affiliate businesses in the state; in anticipation of the lost revenues, Amazon cut off all these affiliates overnight. [7] California has also introduced legislation, California Assembly Bill 178.

New York has gone beyond this, passing a law to collect sales taxes from Web retailers with no physical presence in the state, affiliates or otherwise. It has been challenged by Amazon and Overstock.com, who contest that it violates previous laws dictating that a company must have a physical presence in the state for the state to collect sales tax from it. In 2009, the New York Supreme Court has ruled against Amazon in this matter; Amazon plans to appeal to ruling (to the Supreme Court, if possible).[8] If the law is not overturned on appeal, it may entice other states to pass similar laws, damaging Amazon's revenue across the country.

Dependence on Technology and Cloud Computing

Amazon's business is dependent upon their technology infrastructure not malfunctioning, causing potentially damaging outages for the website. AMZN has invested heavily in the area of cloud computing, to provide them with flexibility in the management of their infrastructure, even providing a public cloud computing offering, Amazon EC2. However, EC2 experienced extended outages in October 2007 and February 2008, demonstrating growing pains in the discovery of this new technology. On July 19, 2009, AMZN experienced 15 minutes during which customers were unable to access the main page. [9] While these events by themselves may not have a huge impact on the business, a long-lasting disruption in the website's functionality would be tremendously detrimental in the very competitive online retailer market, and damage their credibility as a provider of cloud computing services.

Risks and Opportunities

Early in its history, investors and analysts loved to compare Amazon to other ecommerce competitors like Buy.com, Overstock.com, Bn.com, and Walmart.com. But over the years, such comparisons have been made with decreasing frequency. One of the main reasons this has been the case is that Amazon’s largest competitor isn’t any one company, it’s the fact that the vast majority of retail sales in the US and across the world still occurs in brick and mortar stores. While the penetration of online sales varies by category (in the US: 1% penetration in food, 22% in computer peripherals), online sales still represent only a small percent of the US retail market overall. The continuing shift towards online purchasing is a major trend which should provide Amazon with sustained long-term growth potential. Amazon’s continued focus on increasing selection and availability, lowering prices, and providing a great product and service are keystones of its long-term growth strategy.

As Amazon continues to expand into new categories and markets and to experiment with building new kinds of businesses, substantial investments will be made today in the hopes of planting the seeds that will become substantial revenues opportunities in the future. Many of these bets will fail, but even if a few of them succeed, they could translate into incredible businesses for the company.